Insider

The IRS has issued a helpful general information letter on automatic compensation reduction elections (also known as “automatic enrollment,” “passive enrollment” and “negative elections”) for contributions to 401(k) plans and 403(b) plans. Under such elections, eligible employees automatically contribute to a plan unless they opt out. This practice generally increases a 401(k) plan’s contribution rates and helps the plan pass 401(k) nondiscrimination testing.

Previous IRS guidance generally provided that automatic enrollment is allowed, as long as employees receive enough notice to have an effective opportunity to opt out and receive the cash instead (see Watson Wyatt Insider, March 2000). The new IRS letter clarifies that:

• The compensation reduction percentage need not be the 3 percent or 4 percent in the prior guidance. It may be any percentage of compensation permitted for contributions made under an affirmative, explicit election (i.e., in which the default is no contribution).



• A plan’s automatic compensation reduction percentage may change over time, pursuant to a specified schedule. However, the notices to employees must describe the amounts and timing of any planned changes.



• The automatic enrollment or an increase in the automatic compensation reduction percentage may apply partly or entirely to future increases in or supplements to compensation (including pay raises and bonuses). However, the notices to employees must describe how the automatic enrollment would apply to any such future compensation increases or supplements.

Of course, the amount of an automatic compensation reduction election remains subject to all applicable numerical limitations, such as the dollar limit on salary reductions ($13,000 for 2004).

Sponsors of 401(k) and 403(b) plans may want to consider instituting automatic enrollment or, if they already have automatic enrollment, changing the design. For more information, please contact your Watson Wyatt consultant.